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Supply Theories of the Business Cycle

February 13, 2013

Supply theories of the business cycle explain why production is more difficult in recessions. Supply theories contrast to demand theories which focus on recessions caused by decreased spending.

Goods must be produced before they are consumed. Cars must be assembled before they are driven and food must be grown before it is eaten. Hence, more difficult production unavoidably means lower consumption and investment. There isn’t much the central bank or fiscal policy can do to fix supply side recessions. Corrective policy must be tailored to the specific requirements of what is causing the problem.

Examples of supply side recessions

  • A drought makes growing crops more difficult. As a result, people are able to eat less and must either use their stored grain or starve.
  • Conflict in oil producing nations results in higher gas prices, which ripples through the economy affecting the goods which are shipped long distances.
  • The government passes a poorly thought out law which makes operating businesses more expensive resulting in layoffs and higher prices.
  • A natural disaster destroys buildings and kills a lot of people.

Stylized Facts
It’s not that either “all recessions are caused by demand problems” or “all recessions are caused by supply problems” and we just have to figure out which one is right. Each recession is caused by a mix of supply and demand factors. In order to figure out which of the two forces are more prevalent, economists look at stylized facts, which are not facts, but simply patterns of information which can be interpreted to understand underlying forces.

Both consumption and investment are procyclical in both supply and demand side recessions. That means that they go up when the economy is doing well and down when it is in a recession. Consumption is very stable relative to investment; in a recession, consumption goes down a little bit, but investment plummets. Employment is also procyclical in both types of recessions.

The variables where the two types of recessions split are prices, real wages, and average labor productivity. If production becomes more difficult, supply curves will shift to the left increasing prices. There is just as much money as there was before, but now it is chasing fewer goods and so prices get bid up.

Supply Shock Graph
Supply decrease

In supply side recessions, real wages fall because productivity and production falls. Since workers are paid proportionately to what they produce, their wages must fall. Even when workers’ money (nominal) wages are stable, they face higher prices and therefore can’t buy as much as they could before the recession.

Sectoral Shifts
Prices direct economic activity. When a price increases due to a supply shock, that encourages people to shift what they buy to cheaper alternatives. Profits drop in the affected industries, causing investment and workers to flow to other sectors of the economy. These “sectoral shifts” costly. Not only do workers need to be retrained, but capital, the equipment and buildings used to produce goods, is often custom-made for one particular industry, and cannot be repurposed to a new sector or production method.

For example:
Let’s say you have a country where much the population is farmers, and much of the capital consists of farming equipment and irrigation systems. Global warming comes along and turns the climate from temperate to tropical. Farmers need to switch crops from rye to mangoes, and they must get new equipment and learn new skills. Cooks no longer are able to use their baking skills and must learn to make mango lassis. The transportation network needs to change to deal with the fact that food spoils faster in the hot sun. Changes in one sector of the economy force lots of other sectors to make adjustments to cope with the change.

Policy Responses
Supply shocks do not lend themselves to one size fits all policy responses. Because the technology of production can change in many different ways, you can’t predict how policy might have to change to correct for it. Economists often suggest that policymakers should make the economy as flexible as possible in order to minimize the time and cost of transitioning to the new patterns of production. Trying to prevent the transition simply prolongs the pain and can make the economy stagnate. Economists call the process where newer, more efficient modes of production replace older outdated ones “creative destruction“, to highlight the fact that any economic growth often involves destruction of the old ways of producing. There is no growth without change, and without change, we’d still all be subsistance farmers barely scraping together enough food to survive.

Further Reading
Tyler Cowen on Real Business Cycle Theory (video)
Bad outcomes lead to bad policy
Arnold Kling on Patterns of Specialization and Trade
The problem is 75% demand shortfall, and 75% structural

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